Page 274 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 12: Inventory Management

Inventory ordering costs and inventory carrying costs are used to compute the optimum size Notes
inventory. Inventory shortage costs are included in determining the optimum reorder point for
inventory items.
Reorder point: The economic order quantity provides a manager with information about the
optimum order size for a particular item of inventory but it does not provide information about
when the order should be placed. The reorder point is the inventory level of which the order is
placed. If a firm has the ability to buy and receive inventory items instantly, a new order is
placed when there are no more units on hand.
Unfortunately, few firms are able to get instant deliveries. Sometime is required between placing
an order and receipt of the goods. This time period is called lead-time. If the lead-time is known
and daily demand is known, the reorder point is easy to find.

Example: SWT Company has a lead-time of 8 days for tyre orders. The daily demand is
50 tyres. The lead-time demand or demand during lead-time is 8 × 50 = 400 tyres. If the company
plans to receive a new tyre shipment just as the inventory reaches zero, it should place an order
when the inventory level reaches 400 tyres. A new order is placed at an inventory level of 400
tyres, 8 days before inventory reaches zero.

12.1.3 Inventory under Uncertainty and Safety Stock

The use of lead-time and lead-time demand in the analysis of reorder point assumes a known
constant demand and lead-time often one or both of these fluctuate and are not known. Demand
in particular is difficult to predict, because it can change from day-to-day. Delivery of inventory
is affected by the suppliers inventory levels and operating efficiency, as well as, by variations in
delivery schedules of common carriers.
When lead-time or demand is uncertain, the analysis of the inventory reorder point is complicated.
There may be a situation of possibility of remaining out of inventory, which is known as
stockout. Running out of stock involves cost by way of lost profit in potential sales, customers
ill will, or the loss of the customer altogether. Raw materials inventory stockouts may cause
expensive start up costs, production inefficiencies, a switch to more expensive raw materials or
penalty costs for late delivery of contracted goods. Often, it is difficult to estimate stockout costs.
In order to avoid stockout costs, firms sometimes carry a safety stock, which is additional
inventory above what is needed. Safe stock is a cushion that the management uses to avoid on
interruption of normal activities due to stockouts.
The optimum inventory strategy is to increase safety stock as long as cost of carrying the
additional inventory is less than the expected cost of stockouts. The expected stockout cost is the
cost of the stock out multiplied by its probability of occurring.

Example: Gross margin is 35 per unit. Expected demand of 50 units per day means that
a 1-day stock-out results in a stock out cost of 35 × 50 or 1,750. Management estimates that
with the safety stock, there is a 30 per cent chance of stock out. The expected cost of a stockout is:
Expected stockout = stock out cost × probability of stockout
= 1750 × 0.30 = 525
The optimum strategy is to carry enough safety stocks that the cost of carrying the safety stock
equals the expected cost of a stock out with a carrying cost of 12 per unit; the optimum safety
stock is (525/12) i.e., 44 tyres. With a 30 per cent chance of a stockout, the arbitrary 100-unit safety

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